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Coase, Institutionalism, and the Origins of Law and Economics

Ronald Coase merged two traditions in economics, marginalism and institutionalism. Neoclassical economics in the 1930s was characterized by an abstract conception of marginalism and frictionless resource movement. Marginal analysis did not seek to uncover the source of individual human preference or value, but accepted preference as given. It treated the business firm in the same way, focusing on how firms make market choices, but saying little about their internal workings.

“Institutionalism” historically refers to a group of economists who wrote mainly in the 1920s and 1930s. Their place in economic theory is outside the mainstream, but they have found new energy with the rise of behavioral economics and socio-economics. The institutionalists emphasized the importance of human created institutions that allocate resources and power, institutional rules of social control, and the effect of institutions on the economy. The institutionalists severely qualified marginalist analysis as well as the emergent neoclassical creed that the study of naked individual preference is the exclusive methodology of economic science. By contrast, most institutionalists defended the study of the biological and behaviorist sources of preference. Finally, unlike mainstream neoclassicists, most institutionalists believed that market exchange is only one of many institutions that move resources through the economy.

Coase’s work merged neoclassicism with institutionalism by incorporating marginalist analysis into the study of institutions. As the neoclassicists, he was not concerned about the source of preferences but only with the mechanisms by which they are asserted. More explicitly, by recognizing individual preference orderings and market exchange as the only efficient movers of resources, he reduced the problem of resource movement to one of “transaction costs.” The result was a new brand of institutionalism that was far more palatable to neoclassicists but largely unacceptable to traditional institutionalists.

This revised institutionalism became an important source of theory for modern law and economics. First, it recognized marginalism and the conception of the rational actor as central to economic analysis of legal institutions. Second, it preserved the Pigouvian, fundamentally institutionalist concern that economics consider the costs of moving resources from one spot to another. Third, its market-oriented marginalism led Coase to assume that the only relevant costs of resource movement are the internal value maximizing decisions of individual economic agents, captured by Coase’s 1937 essay on The Nature of the Firm; and the costs of bargaining, reflected in his 1959 and 1960 articles on social cost.